Monday, December 21, 2009

From a recent piece by Michael Hudson (h/t Leo Kolivakis), economist and author of ‘Trade, Development and Foreign Debt’:

Bad economic content starts with bad methodology. Ever since John Stuart Mill in the 1840s, economics has been described as a deductive discipline of axiomatic assumptions. Nobel Prize winners from Paul Samuelson to Bill Vickery have described the criterion for economic excellence to be the consistency of its assumptions, not their realism. Typical of this approach is Nobel Prizewinner Paul Samuelson's conclusion in his famous 1939 article on "The Gains from International Trade":

'In pointing out the consequences of a set of abstract assumptions, one need not be committed unduly as to the relation between reality and these assumptions.'

This attitude did not deter him from drawing policy conclusions affecting the material world in which real people live. These conclusions are diametrically opposed to the empirically successful protectionism by which Britain, the United States and Germany rose to industrial supremacy.

Typical of this now widespread attitude is the textbook Microeconomics by William Vickery, winner of the 1997 Nobel Economics Prize:

Economic theory proper, indeed, is nothing more than a system of logical relations between certain sets of assumptions and the conclusions derived from them ...

'The validity of a theory proper does not depend on the correspondence or lack of it between the assumptions of the theory or its conclusions and observations in the real world. A theory as an internally consistent system is valid if the conclusions follow logically from its premises, and the fact that neither the premises nor the conclusions correspond to reality may show that the theory is not very useful, but does not invalidate it. In any pure theory, all propositions are essentially tautological, in the sense that the results are implicit in the assumptions made.'

Such disdain for empirical verification is not found in the physical sciences. Its popularity in the social sciences is sponsored by vested interests. There is always self-interest behind methodological madness.

That is because success requires heavy subsidies from special interests who benefit from an erroneous, misleading or deceptive economic logic. Why promote unrealistic abstractions, after all, if not to distract attention from reforms aimed at creating rules that oblige people actually to earn their income rather than simply extracting it from the rest of the economy?

Essentially, Michael is highlighting statements from some of the pioneers of modern economics in which they assert that the quality of an economic theory is independent of the theory’s ability to describe reality. Instead they suggest that economic theory is valid if it is supported by a series of logical constructs that begin with sound premises.

The economics profession has thus denounced its own usefulness, and relegated itself to the same epistemological bucket as astrology, voodoo and tarot card reading.

Hudson goes on to attribute the ubiquitous acceptance of modern ecnomics as sound 'science' to the special interests who stand to benefit from a perpetuation of the status quo.

Wednesday, December 9, 2009

Most economists and analysts do a poor job of capturing the juxtaposition between normal cyclical recovery expectations and long-term headwinds from structural consumer over-indebtedness. Those who argue for a perpetuation of the consumer credit cycle that began post WWII and accelerated exponentially starting in 1982, with a steepening in 1994, must implicitly believe that household debt can grow to the sky.

If instead we acknowledge that households have accumulated new debt equal to 50% of rolling GDP since 1980 (chart below), thereby doubling aggregate household debt outstanding to ~102%, this implies a 2.4% p.a. boost to aggregate consumer spending over that time period. Assuming average consumer spending as a proportion of GDP was 65% over this horizon, this amounted to a boost of ~1.6% p.a. to U.S. GDP.

This analysis is upwardly biased by mortgage debt, which only flows through to GDP in the form of rents, new home construction and sales, and consumption funded by 2nd mortgages or home equity lines of credit. If we just take the increase in consumer credit (revolving and non-revolving) since 1980 (chart below), which has increased from 12.93% of GDP to 17.988% of GDP, our analysis yields a boost of 1.15% p.a. as a result of this new consumer debt. With consumer spending at 65% of GDP this would have resulted in a boost of 0.75% p.a. from unsecured lines of credit, credit card debt, and car loans alone.

It is difficult to know to what degree mortgages to purchase existing homes biased the first analysis higher, or to what degree not accounting for home equity lines of credit and second mortgages biased the second analysis lower. I think it is safe to say, however, that the annual boost to U.S. GDP from the expansion in consumer debt is between 1% and 1.25% per annum between 1980 and 2009.

Importantly, if consumer debt somehow remains constant at current nosebleed levels going forward, U.S. GDP will grow at a rate 1% - 1.25% below average growth rates since 1980. If however consumers pay-down debt at the same pace that they accumulated it from 1980 - 2008, GDP growth will drop by a further 1% - 1.25%. This would then shave a total of 2% - 2.5% from GDP growth potential, which puts likely growth rates for U.S. GDP between 1% and 2% p.a. for the foreseeable future, barring the creation of another consumer credit cycle.

Interestingly, Japanese GDP growth averaged 1.9% during its 'Lost Decade' from 1990 - 2000 after posting 10+ years of 3 - 4% growth leading up to the Nikkei's 1989 peak. Despite aggressive policies by the BOJ to bring rates to zero and a massive buildup in Japanese government debt to offset corporate and household balance sheet rebuilding, Japanese GDP was exceedingly volatile through the 1990s and share prices dropped by 65% over the decade. Of course, they are almost 75% below their 1989 peak today.

Given this anemic consumption scenario, and the Japanese template for a debt deflation scenario, investors should be asking to what degree the market is discounting a long period of slower economic growth. With consumers retrenching, boomers retiring, and government indebtedness likely to necessitate higher corporate and personal taxes in the future, is it likely that stock market valuations will continue to hold at 1980 - 2008 levels relative to the size of the economy? Or is it possible that they may revert to levels that dominated for most of the last century.

Tuesday, December 1, 2009

John Hussman manages the eponymous Hussman Funds. Hussman was among the few who both forecast the 2008/2009 credit crisis, and also had the fortitude to position his clients' defensively in advance. Returns this year have lagged global stocks, but Hussman is largely unrepentant. Like us, he lacks faith in the sustainability of the current rally, and rails against the unconstitutional actions of the Fed in supporting the bondholders of egregiously mismanaged banks.

Dr. Hussman writes a weekly column at his web site, which I strongly encourage everyone to read. This is his latest piece.

November 30, 2009

Reckless Myopia

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

I was wrong.

Not about the implosion of the credit markets, which I urgently warned about in 2007 and early 2008. Not about the recession, which we shifted to anticipating in November 2007. Not about the plunge in the stock market, which erased the entire 2002-2007 market gain, which was no surprise. Not about the “ebb and flow” of short-term data, which I frequently noted could produce a powerful (though perhaps abruptly terminated) market advance even in the face of dangerous longer-term cross-currents. I expect not even about the “surprising” second wave of credit distress that we can expect as we move into 2010.

From a long-term perspective, my record is very comfortable. But clearly, I was wrong about the extent to which Wall Street would respond to the ebb-and-flow in the economic data – particularly the obvious and temporary lull in the mortgage reset schedule between March and November 2009 – and drive stocks to the point where they are not only overvalued again, but strikingly dependent on a sustained economic recovery and the achievement and maintenance of record profit margins in the years ahead.

I should have assumed that Wall Street's tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability. The eagerness of investors to chase prevailing trends, and their unwillingness to concern themselves with predictable longer-term risks, drove a successive series of speculative advances and crashes during the past decade – the dot-com bubble, the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble.

And here we are again.

We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let's face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we've already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.

Taking the weighted average outcome for the two states of the world still produces a poor average return/risk tradeoff. Taking the weighted average investment position for the two states of the world is somewhat more constructive. As I noted several weeks ago, I have adapted our weightings accordingly. As a result, we have been trading around a modest positive net exposure, increasing it slightly on market weakness, and clipping it on strength, as is our discipline. Currently, the Strategic Growth Fund has a net exposure to market fluctuations of less than 10%, but enough “curvature” (through index options) that our exposure to market risk will automatically become more muted on market weakness and more positive on market advances, allowing us to buy weakness and sell strength without material concern about the (increasing) risk of a market collapse.

There is no chance, even in hindsight (“could have, would have, should have” stuff) that I would have responded to the existing evidence in recent months with more than a moderate exposure to market risk during some portion of the advance since March. But our year-to-date returns might now be into a second digit had I recognized that investors have learned utterly nothing from the bubbles and collapses of the past decade. That recognition might have encouraged a greater weight on trend-following measures versus fundamentals, valuations, price-volume sponsorship, and other factors.

Still, our stock selections continue to perform well relative to the market, our risks remain well-managed through a substantial (though not full) hedge, and our investment approach has nicely outperformed the S&P 500 over complete market cycles, with substantially less downside risk than a passive investment approach. We have implemented some modest changes to improve our potential to benefit from (even ill-advised) speculative runs, but we've done fine nonetheless, and we can sleep nights.

Whether or not I have focused too much on probable “second-wave” credit risks is something we will find out in the quarters ahead – my record of economic analysis is strong enough that a “miss” on that front would be an outlier. What I do think is that over the past decade, investors (including people who hold themselves out as investment professionals) have become far more susceptible to reckless myopia than I would have liked to believe. They have become speculators up to the point of disaster.

Frankly, I've come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and predictable crashes over the recent decade makes that clear. Rather, investors appear to respond to emerging risks no more than about three months ahead of time. Worse, far too many analysts and strategists appear to discount the future only in the most pedestrian way, by taking year-ahead earnings estimates at face value, and mindlessly applying some arbitrary and historically inconsistent multiple to them.

This is utterly different from true discounting – which does not rely on multiples, but instead carefully traces out the likely path of future revenues, profit margins, cash flows and earnings over time, and explicitly discounts expected payouts and probable terminal values back at an appropriate rate of return. That's what we actually do here. Talking in terms of multiples can make the process easier to explain, and can be a reasonable approach to the market as a whole if earnings are normalized properly, but ultimately, an investment security is a claim to a long-term stream of cash flows. It is not simply a blind multiple to the latest analyst estimate.

Fortunately, the evidence suggests that the long-term returns to a careful discounting approach tend to be strong even if investors repeatedly behave in speculative and short-sighted ways. This is because long-term returns are fully determined by the stream of cash flows actually received by investors over time, and because inappropriate valuations ultimately tend to mean-revert. In the face of speculative noise, the long-term returns from a proper discounting approach may not capture as much speculative return as might be possible, but over time, many of those speculative swings tend to wash out anyway.

In part, the market's increasing propensity toward speculation reflects the increasing lack of fiscal and monetary discipline from our leaders. Policy makers who seek quick fixes and could care less about long-term consequences undoubtedly encourage investors to embrace the same value system. Paul Volcker was the last Fed Chairman to have any sense that discipline and the acceptance of temporary discomfort was good for the nation.

Our current Fed Chairman's voice literally quivers in response to the phrase “bank failure,” even though in the present context, a bank failure implies none of the disorganized outcomes that characterized the Great Depression. It simply means that the bondholders take a loss and the remaining part of the institution survives intact as a “whole bank” entity (and can be sold or re-issued back to public ownership, less the debt to bondholders, as such). The same outcome would have been possible with Lehman had the FDIC been granted authority from Congress to take conservatorship of a non-bank financial entity.

In my estimation, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. This is not certainty, but the evidence that we've observed in the equity market, labor market, and credit markets to-date is simply much more consistent with the recent advance being a component of a more drawn-out and painful deleveraging cycle. Meanwhile, valuations are clearly unfavorable here, and even under the “typical post-war recovery” scenario, we are observing an increasing number of internal divergences and non-confirmations in market action.

As Gluskin Sheff chief economist David Rosenberg noted last week, “Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly.

“This is why people didn't figure out that it was the Great Depression until two years after the worst point in the crisis in the 1930s; and why it took decades, not months, quarters or even years, for the complete transition to the next sustainable economic expansion and bull market.

“Mortgage applications for new home purchases hit a 12-year low in the middle of November (down 22% in the past month!), fully two weeks after the Administration said it was going to not only extend but expand the program to include higher-income trade-up buyers. Once again, there is minimal demand for autos and housing, and that is partly because the market is still saturated with both of these credit-sensitive big-ticket items after an unprecedented credit and consumer bubble that went absolutely parabolic in the seven years prior to the collapse in the financial markets an asset values. We are probably not even one-third of the way through this deleveraging cycle. Tread carefully.”

Andrew Smithers, one of the few other analysts who foresaw the credit implosion and remains a credible voice now, concurred last week in an interview with my friend Kate Welling (a former Barrons' editor now at Weeden & Company): “The good news so far is that the stock market got down to pretty much fair value or even, possibly, a tickle below it, at its March bottom. But now it has gone up… we probably have a market which is, roughly, 40% overpriced. In order to assess value, it is necessary either to calculate the level at which the EPS would be if profits were neither depressed nor elevated, or to use a metric of value which does not depend on profits. The cyclically adjusted P/E (CAPE) normalizes EPS by averaging them over 10 years. It thus follows the first of those two possible methods. Using even longer time periods has advantages, particularly as EPS have been exceptionally volatile in recent years - and using longer time periods raises the current measured degree of overvaluation. The other methodology we use measures stock market value without reference to profits: the q ratio. It compares the market capitalization of companies with their net worth, also adjusted to current prices. The validity of both of these approaches can be tested and is robust under testing - and they produce results that agree. Currently, both q and CAPE are saying that the U.S. stock market is about 40% overvalued.”

In the chart below, the current data point would be about 0.4, not as extreme as we observed in 1929, 2000, or 2007 of course, but equal to or beyond what we've observed at virtually every other market peak in history. This aligns well with our own analysis, where as I've noted in recent weeks, the S&P 500 is priced to deliver one of the weakest 10-year total returns in history except for the (ultimately disappointing) period since the mid-1990's.

One of the fascinating aspects of the past few months is the lack of equilibrium thinking with respect to what happened to the trillions of dollars in government money that has been spent to defend the bondholders of mismanaged financial companies. Almost by definition, money given to corporations will show up most quickly as improvements in corporate earnings, and then slightly later, as executive compensation. A few pieces came across my desk last week, hailing the ability of the corporate sector to bounce back from the recent economic downturn even though revenues have continued to suffer and employment has been steeply cut. Why is this a surprise? Where else could the money have gone? Labor compensation? It is truly mind-numbing that a moment after a temporary surge of trillions of dollars, borrowed and tossed out of a helicopter (though to specific corporations and private beneficiaries), analysts would hail a subsequent improvement in corporate results as evidence of “resilience.”

What matters is sustainability, and unfortunately, it is clear that credit continues to collapse. Banks are contracting their loan portfolios at a record rate, according to the latest FDIC Quarterly Banking Profile. Even so, new delinquencies continue to accelerate faster than loan loss reserves. Tier 1 capital looked quite good last quarter, as one would expect from the combination of a large new issuance of bank securities, combined with an easing of accounting rules to allow “substantial discretion” with respect to credit losses. The list of problem institutions is still rising exponentially. Overall, earnings and capital ratios have enjoyed a reprieve in the past couple of quarters, but delinquencies have not, and all evidence points to an acceleration as we move into 2010.

Urgent Policy Implications

From a policy standpoint, it is effectively too late to forestall further foreclosures absent explicit losses to creditors. The best policy option now is to make sure that the second wave does not result in a debasement of the U.S. dollar. The way to do that is to require three things:

First, the FDIC should be given regulatory authority to take non-bank financials into conservatorship the way they should have been able to do with Bear Stearns and Lehman. If this authority had existed in 2008, Bear's bondholders would not now stand to get 100% of their money back, with interest, as they presently do, and Lehman's disorganized liquidation would have been completely unnecessary. As I've noted before, the problem with Lehman was not that it went bankrupt, but that it went bankrupt in a disorganized way. If the FDIC had authority over insolvent non-bank financials and bank holding companies, it could wipe out equity and an appropriate amount of bondholder capital, and sell the fully-functioning residual to an acquirer, as is typically done with failing banks, without any loss to depositors or customers.

Second, bank capital requirements should be altered to require a substantial portion of bank debt to be of a form that automatically converts to equity in the event of capital inadequacy. This would force losses onto bondholders, rather than onto taxpayers. This policy adjustment is urgent – we have perhaps a few months to get this right.

Finally, Congress should be clear that government funds will be available only to protect the interests of depositors, not bondholders. Specifically, any funds provided by the government should be contingent on the ability to exert a senior claim to bondholders in the event of subsequent bankruptcy, even if a category is created to allow those funds to be counted as “capital” for purposes of satisfying capital requirements prior to such bankruptcy. Government-provided capital should be subordinate only to depositor claims, if equity and bondholder capital ultimately proves insufficient to meet those obligations.

Since early 2008, beginning with the provision of non-recourse funding in the Bear Stearns debacle, the Federal Reserve and the Treasury have repeatedly allocated or implicitly obligated public funds to defend the bondholders of mismanaged financial companies. This has included the outright and non-recourse purchase of nearly a trillion dollars in mortgage securities that have no explicit guarantee by the U.S. government. By purchasing these securities outright (rather than through a well-defined repurchase agreement), the Fed is effectively obligating the U.S. government to either guarantee them or to absorb any future losses.

Aside from the fraction of bailout funding that was specifically allocated by Congress through legislation, these actions represent an unconstitutional breach into enumerated spending powers that are the domain of the elected members of Congress alone. The issue here is not whether the Fed should be independent from political influence. The issue is the constitutionality of the Fed's actions. The discretion that it has exerted over the past two years crosses the line into prerogatives reserved for Congress. That line needs to be clarified sooner rather than later.

Emphatically, the trillions of dollars spent over the past year were not in the interest of protecting bank depositors or the general public. They went to protect bank bondholders. Instead of taking appropriate losses on those bonds (which financed reckless mortgage lending), those bonds are happily priced near their face value, for the benefit of private individuals, thanks to an equivalent issuance of U.S. Treasury debt. But that's not enough. Outside of a very narrow set of institutions that are subject to compensation limits, just watch how much of the public's money – which benefitted several major investment banks following a very direct route – gets allocated to Wall Street bonuses in the next few weeks.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and mixed market action. The market remains significantly overbought on an intermediate-term basis, and we've seen increasing divergences from breadth, small and mid-cap stocks, trading volume, and other internals, which have lagged the most recent advance in the S&P 500 and other cap-weighted indices.

The prospect of a debt-repayment “standstill” from Dubai prompted some weakness in foreign markets that spilled over to the U.S. on Friday. This was interesting given that David Faber reported the issue on CNBC on Wednesday, to no reaction. Importantly, the payment difficulties do not stem from oil revenues, but largely from tourism and financial activity, as those are Dubai's chief industries (Dubai is home to the tallest building and the largest man-made islands in the world, for example). From that standpoint, it is difficult to imagine much in the way of contagion as a result of Dubai's difficulties.

Whatever shock the market will get from left field is likely to come from larger financial or geopolitical risks. The market for credit default swaps bears watching, but thus far we haven't observed spikes to indicate that something major is imminent. Unfortunately, as I noted earlier, investors have earned an “F” for vigilance in recent years, so our lead time on new difficulties may be shorter than we might like.

In any event, I'm pleased with the overall behavior of our stock holdings, and I expect that we'll have plenty of opportunity to increase our exposure to market fluctuations at more appropriate valuations. Presently, we've got a small amount of exposure to market fluctuations, but not enough to cause any material difficulties if the market experiences some trouble. The largest source of day-to-day fluctuations remains the difference in performance between the stocks we hold long and the indices we use to hedge. That source of risk has also been the primary contributor to returns over the life of the Fund.

In bonds, the Market Climate was characterized last week by moderately unfavorable yield levels and generally favorable yield pressures. We saw a good example of how the market is inclined to respond to fresh credit concerns last week, with upward pressure on the U.S. dollar and U.S. Treasuries, and downward pressure on foreign currencies and commodities. While I continue to believe that the dollar faces substantial risk of further erosion in its exchange value, as well as a near doubling of the CPI over the coming decade or so (both reflecting the massive increase in U.S. government liabilities in recent years), those prospects are not likely to emerge until risk-aversion about credit default materially abates. Credit concerns typically create a spike in demand for default-free assets such as U.S. government liabilities, so even though there is a much larger float than is likely to be sustained over time without inflation as the ultimate outcome, credit concerns tend to support the value of these liabilities and hence mutes immediate inflation pressures (essentially, monetary velocity declines as these liabilities are sought as a default-free store of value).

The Strategic Total Return Fund currently has an overall duration slightly over 3 years, primarily in straight Treasuries, with a small 1% exposure to precious metals shares and about 4% of assets in utility shares.

Finally, it is the long term investor, he who most promotes the public interest, who will in practice come in for the most criticism, wherever investment funds are managed by committees, boards, or banks.

For it is the essence of his behaviour that he should be eccentric, unconventional, and rash in the eyes of average opinion.

If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.

Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

Disclaimer

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